Last year, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced their intention to proceed with plans that have been in the works for some time to fundamentally change lease accounting standards. These changes will overturn a half-century of accounting practices under U.S. GAAP as they relate to accounting for leases.
The new standards are expected to require construction companies and contractors to report long-term lease liabilities as fixed asset liabilities on their balance sheet, instead of as a footnote in their financial statements. Long-term leases are defined as leases that are longer than 12 months in duration.
This change will have a significant impact on the financial statements of many construction companies and contractors, as it will impact lease accounting practices for all tangible property including real estate, buildings, machinery and equipment. A firm implementation date for the new lease accounting standards has not yet been announced, but is expected to be no later than 2016 or 2017. However, since companies will have to present two years of data when the standards are implemented, getting an early start on the analysis will be important.
What the Change Means
The primary impact of the change in lease accounting standards will be the addition of more debt and leverage to construction companies’ and contractors’ balance sheets. This could impact the ability to qualify for much-needed financing, such as bank lines of credit that many contractors rely on to manage the cash flow delays that are inherent in most construction projects.
Here’s why: Banks often require borrowers to meet minimum standards of tangible net worth, debt-to-equity and other financial ratios. By adding more debt and leverage to the balance sheet, the shifting of long-term leases to the balance sheet will negatively impact these ratios for many contractors. Similarly, bonding companies also keep a close eye on financial ratios, so the change could impact contractors’ bonding capabilities as well. If banks and bonding companies don’t change their viewpoints on acceptable levels of leverage, then this could negatively impact how they look at the financial statements.
Another possible impact of the change in lease accounting standards has to do with the use of related party transactions as a tax-saving technique. Contractors often establish a separate entity that is owned by a principal — i.e., a related party transaction — to purchase and own real estate or equipment and then lease it back to the contractor. This removes the fixed assets and debt from the balance sheet, thus potentially saving taxes. Under the new standards, the fixed assets will be moved back to the balance sheet, thus lessening the tax benefits. However, the strategy may still make sense for many contractors for tax and legal liability purposes.
Three Types of Leases
The new lease accounting standards will create three new types of lease categories:
- Short-term Leases — These are leases with a term of 12 months or less. They essentially are not impacted by the new standards and can continue to be treated as traditional operating leases.
- Type A Leases — These leases typically apply to all assets other than buildings or land, unless the lease term or lease payments are insignificant to the asset’s economic life or the fair value of the underlying asset. They are recorded on the balance sheet as a right-to-use leased asset and a corresponding lease liability, and the asset is amortized in a pattern in which the lessee expects to consume the right-of-use asset’s future economic benefits.
- Type B Leases — These leases typically apply to buildings or land, unless the lease term or lease payments are significant to the asset’s economic life or the fair value of the underlying asset. They are also recorded on the balance sheet as a right-to-use leased asset and a corresponding lease liability, and the asset is amortized straight-line over the lease term.
Start Planning Now
While the implementation date for the new lease accounting standards may seem a long way off, it is not too early to begin planning for how they might impact your firm. A good first step is to perform a “what if?” analysis, starting at the top of your organization and working down. This will enable you to determine what your financial statements will look like under the new standards and decide what changes need to be made to your financial operations, and when they need to be made, to ensure that your firm is both compliant and efficient when the new standards become effective. For example:
- What if you had to provide financial information for the new standards right now?
- What would that information look like?
- Would you be able to produce this information in a timely manner?
- How would the new standards impact your tangible net worth, debt-to-equity and other key financial ratios?
- Would these impacts knock you out of compliance with bank loan covenants or the requirements of your bonding companies?
- If so, how flexible will your bank or bonding company be in working with you to avoid negative repercussions on your firm?
Performing a what-if analysis now will enable you to make strategic changes in your financial management and operations that will make the transition to the new lease accounting standards go much more smoothly when the time comes. You’ll be better prepared to either modify your existing financial reporting system or install a new system that will provide the functionality necessary for you to comply with the standards.